Posts from January 2009

When Talking About Business Models, Remember That Profits Equal Revenues Minus Costs

There is no shortage of discussion about Internet business models these days. And they almost always focus on revenues. But revenues are only half of the value creation equation. The other half is costs.

Let me explain. Businesses are worth the net present value of future cash flows. Cash flows means profits basically (capital expenditures are important but I'm going to leave them out of the discussion on this post). So a business is worth the sum of all of its future profits, discounted back to a net present value. For those who don't want a lesson in finance, you can simplify this theory even more by using a cash flow multiple as a proxy for a net present value. I like to use a 10x multiple for cash flow as a simplistic proxy for net present value.

So with that simplification, the value of a business is approximated by 10 x (revenues – costs). You can focus on creating value by driving revenues or you can focus on creating value by driving profits. And they are not the same. Because costs don't have to grow linearly with revenues.

Chris Anderson wrote a very good piece in today's WSJ called The Economics Of Giving It Away. In that essay, Chris wrote:

Meanwhile YouTube is still struggling to match its popularity with
revenues and Facebook is selling commodity ads for pennies after its
effort to charge for intrusive advertising led to a user backlash. And
news-sharing site Digg, for all its millions of users, still doesn't
make a dime. A year ago, that hardly mattered: The business model was
"build to a lucrative exit, preferably in cash." But now the exit doors
are closed and cash flow is king.

Chris goes on to suggest that Internet entrepreneurs are going to have to get people to step up and pay for something instead of just giving everything away for free because advertising isn't going to foot the bill for every company. That may well be true and we are certainly thinking that way for most, if not all, of our portfolio companies. But Chris's examples, particularly Facebook and Digg, are examples of companies that might benefit from looking at the cost side of the profit equation at some point (maybe not yet).

Let's look at Craiglist. I've heard people estimate that they are doing close to $100mm in annual revenues at this point. Many say, "they could be doing so much more". But the Craigslist profit equation is interesting. They apparently have less than 30 employees. That's about $4mm/year in employee costs. Let's assume that they spend another $6mm per year on hosting and bandwidth costs and other costs. So it's very possible that Craigslist's annual costs are around $10mm/year. Their value equation then is 10 x (100-10) = $900mm. That's almost a billion dollars in value for a company with only 30 employees.

The web can do that in more than one company. Last month, Spencer Ante reported that Digg's annual revenues were around $8.5mm. Everyone was saying how bad that was. And maybe it is, but I don't know. It wasn't the revenues that shocked me. It was the costs. Apparently Digg's costs for 2008 were about $14mm and they have over 70 employees and are planning on growing that number to 150 in 2009. Digg is entirely peer produced. It could take a Craigslist approach to its business and keep its headcount to around 30. Then it might be close to breakeven and could grow over time to a business with $30mm to $50mm in revenue and $10mm in costs and $20mm to $40mm in profits. Apparently Digg has been looking for an exit in the neighborhood of $300mm. They could get there with a lean cost structure possibly more easily than investing heavily in new stuff.

Facebook also comes to mind. Last winter, Kara Swisher reported that Facebook was planning on generating revenues of $300mm to $350mm in 2008 and that it would have profits of $50mm, meaning its costs would be $300mm in 2008. She also reported that Facebook would take its headcount to about 1000 by the end of 2008. As Chris said in his WSJ piece, Facebook has been widely derided for the low CPMs it generates (pennies in Chris' words). But instead of deriding the revenues that Facebook is generating, maybe we should be in awe of a $350mm revenue stream coming from a company that produces no content of its own. Why does Facebook need 1000 employees? Why does it need to spend $300mm per year? There may be good reasons. International expansion can be expensive and so is building out a large sales organization. But of course, none of that has to happen. Could Facebook instead cut is headcount back to 500ish and become incredibly profitable and still grow like a weed? I don't know that much about what is going on inside of Facebook and I am not trying to be critical of any one company. I am just trying to make a larger point.

Let's talk about the biggest and most valuable Internet company of them all, Google. Google has one incredibly amazing business – keyword advertising. It relies on its own search service and deals with other search services and content partners for the audience that drives the keyword business. If you stripped that business out of Google, you'd probably have a business that has gross revenues of $20bn, net revenues of $13bn, and operating profits of $8bn to $10bn. That business is worth the approximately $100bn of market value that Google has right now. Everything else is valued at zero becuase it has a lot of costs and no revenue. Could Google unlock a lot of value by giving up on everything else they are doing? Maybe not, but they probably wouldn't lose much value either. I am not suggesting they do that, by the way. But again, I just want to make a point.

The web can create incredibly high operating margin businesses. Craigslist has an operating margin of 90%. Google's keyword business has an operating margin north of 60% (based on net revenues) and possibly higher. Could Facebook and Digg copy those models and create a lot of value on revenue numbers that many think are pitifully small? I think so.

We have a bunch of companies in our portfolio that have done a lot with very little. For example, Tumblr has less than 10 employees, Disqus has 5, Twitter has around 20, Boxee has around 10. These companies are reaching large audiences and creating scale that can be monetized in many ways. We didn't tell these companies to stay small. They told us they could do a lot with a little. And watching them do just that has taught me a lot. Yes, they will all grow this year, most of our companies will. But if they continue to do a lot with a little, their business models will be built on operating margins that are very high and can create a lot of value without a lot of revenue.

I think that's an important part of the economics of the web that are left out of most discussions of Internet business models. Yes, we are turning analog dollars into digital pennies in many cases. But we are also doing the same thing on the cost side, maybe even more so. And I think that "operating leverage" is going to create a lot of value.

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Content Matters

Barry Graubert writes the excellent Content Matters blog and he's got an interview with me up there today.

Here is one question and my answer:

CM: Historically, as the economy comes out of recession, it
creates transformation and change. Which segments have the potential
for transformation in an eventual recovery?

FW: Every
industry that is based on knowledge or information or some other form
of non-physical matter (atoms vs bits) is going to fundamentally
transform and this downturn will be the darwinian forcing function. Think about energy and power systems, banking, media, education. They all have that aspect to them.

There's four more questions and answers so click on this link and go check it out. As a bonus and a treat for me, he put a great clip of the Replacements playing I Will Dare back in the 80s at the end of the post.

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Goodbye Martin

I saw this tweet today and my heart sank

Terrible news from @HLMorgan @martin killed in plane crash at Santa Monica airport yesterday.

Martin Schaedel was someone I met on the internet and got to know a bit over the past few years. He was a funny and mysterious guy. I am not sure he really lived anywhere. He was a VC or an entrepreneur or something else. He was always scheming and working on something.

As Jared Kushner, who Martin introduced me to, said in an email to me this afternoon:

He had great energy, a thirst for adventure and some of the best networking skills I’ve ever seen.

Everytime I met with Martin he would introduce me to at least five people I had to know. That's how he was.

It seems that his thirst for adventure did him in as he died in a plane crash at Santa Monica Airport yesterday. His twitter feed suggests that they were doing some stunts.

I looked all over the Internet for a picture of Martin. He took photos of people everywhere he went but there are no photos of him that I could find. That's typical of the mystery that always seemed to surround him.  [update – finally found one, not great, will keep looking] [update#2 – michiel sent me a photo of martin which I added above]

His blog is called Hello Martin but today, unfortunately, we have to say Goodbye Martin.

Update: Twitter says goodbye to one of its own. This is worth reading particularly if you knew him.

UpdateNextDay: Martin spent the morning of his last day strategizing with the team from GumGum. This photo is from that session and perfectly captures the Martin I knew. Thanks to the GumGum team for sending it to me. And this is the best post I've seen on Martin from a really good friend.


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Our Investment Strategy

My partner Brad was inspired by a visit from David Swensen to the Charlie Rose show to lay out what we invest in and why. It's a great post. Here's my favorite line:

Our investment strategy is to arbitrage the difference between the
capabilities of the new medium and readiness of the existing economic
and social structures to exploit those capabilities.

Click on that link and go read the rest. And let us know what you think in the comments (here or there).

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Advertising This Blog

I've been getting quite a few questions about this lately so I figured I ought to explain the text ads that some of you are seeing around the web for this blog. Here's a screenshot I was sent yesterday by a friend:
Avc sai

I've heard a number of rationalizations for these ads, which have been running for almost a year now, including banner advertising arbitrage, a desperate attempt to shore up declining readership, and taking advantage of declining keyword pricing.

The truth is simpler. I want to use the services of every Union Square Ventures portfolio because I believe that by being an active user of our portfolio's products and services, we can be better investors.

One of our investments is a provider of a keyword advertising service for small and medium businesses called Clickable. Clickable makes it drop dead simple to buy keyword ads across all three major keyword marketplaces (google, yahoo, microsoft). You get daily reports that are simple and easy to understand. And you get recommendations on how to improve your campaigns like "drop these keywords", "change your copy", "increase your prices on these keywords", etc, etc.

So I've been running a campaign to drive traffic to this blog since Clickable went into beta. On a typical day I'll get about 100,000 impressions, about 10-20 clicks, and I'll spend less than $5. Yes, spending $150/month driving traffic to this blog that gives all of its ad revenue to charity seems like a silly idea.

But I've learned a lot about keyword advertising during this process. For example, I've noticed that my keywords are generating a lot more impressions (and more clicks) for me in the past four months. I think that points to some important changes in the keyword marketpace.

But most importantly I've learned a lot about Clickable and how its service works. And I've been able to give the company feedback on how to make the service even easier and more helpful to a small advertiser like me. At $150/month, you can't get much smaller.

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Disqus Adds FriendFeed Integration

A couple days ago Disqus (one of our portfolio companies) announced that they had added FriendFeed integration. This is a feature I've wanted for basically the past year and I am thrilled that they've been able to work with FriendFeed to make this happen.

There are two or three steps. The first one (the or step) is adding your blog's feed to FriendFeed. I've had my feed there for the past year so that was not a necessary step for me. Then you go to the account services page in disqus and add the FriendFeed service, and finally you add FriendFeed comments in the disqus administration panel. It took me about a minute to do the whole thing.

For AVC community members, there are two benefits. The first is if you leave a comment in FriendFeed, it will show up on this blog at the bottom of the comments. You can see them at the bottom of this post from yesterday.
FF comments

It also works the other way. As you can see at the bottom of the FriendFeed comments section, you can post a comment from this blog to FriendFeed.

This isn't perfect in my mind because the FriendFeed comments are not part of the main discussion and are posted at the end of the comments section. I'd prefer that they were fully integrated into the conversation. I also don't know if disqus will email me these FriendFeed comments, and if they do and if I reply to them, will they get posted both on this blog and on FriendFeed? If the answer to that last part is yes, then this is a very big deal to me. I hope Daniel and/or Anton will stop by and answer that question in the comments to this post (and on FriendFeed!).

I don't participate in the FriendFeed discussions and as a result, there aren't many on my content at FriendFeed. Disqus gives me an email (think blackberry) interface to the conversation going on here in this community. And so I am able to be in it all day long even though I am rarely at a desk in front of a computer after 7am most days. If disqus can extend the mobile email interface to FriendFeed, then I can engage there too and I'd get a lot more value out of that community too.

In any case, the comments the posts I write here and send to FriendFeed are no longer silo'd at FriendFeed and that's a great thing. Give it a try and let me know what you think.

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The AVC Music Meetup

I posted a few weeks back about a great music blogging experience with a new band called The Rural Alberta Advantage. The band is from Canada and had never been in the US until this week. Last night they played their first show in the states, here in NYC at Pianos. I was there and the cool thing is so were about half dozen (maybe more) members of this community. I met a bunch of readers for the first time last night. Thanks everyone for coming up and introducing yourself.

For those readers who came out, we got to hang out with the band before and after the show and were treated to a fantastic set. The only bummer was Fraser did not get to hear his favorite track off the new record, called In The Summertime. The band promised to play it when they are back in NYC next friday in Brooklyn at Union Hall.

Here’s a shot of the band at work.

There’s just three of them, Nils is the lead singer/guitar/piano, Amy (who emailed me to start this whole thing off) plays a bunch of fun instruments and sings backup, and Paul is a crazy good drummer. They make a much bigger sound than you’d think. Here’s the first song of theirs I ever heard. Click on the first play button, not the second one.

The Ballad of the RAA – The Rural Alberta Advantage

At the end of the show, instead of an encore, the band walked out into the middle of the audience and sang a song called Goodbye. You’ll probably see a few AVC community members in this photo. Too bad we can’t all tag ourselves in it.

#Music#My Music#NYC

Looking Back On 1999

The Deal launched in September of 1999 and they are celebrating their tenth anniversary this year by looking back on the years they’ve been in business. They asked me to talk about 1999 last week and they published the video of that talk today. If you see some white space at the bottom of the video player, scroll down a bit and it will go away. I’m not sure what’s causing that.

My favorite part of this video is the rummaging around my office bookshelf. Lot’s of good memories are housed there. My one regret is the line about Geocities being the “best deal I ever did”. I owe that deal to my partner at Flatiron, Jerry Colonna. We did the deal together but he brought it in and it would not have happened without him.

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Twenty-Two Years Of Job Creation Wiped Out In One Day

I have worked in three venture capital firms over the past twenty-two years. First at Euclid Partners from 1986 to 1996, then Flatiron Partners from 1996 to now, and Union Square Ventures from 2004 until now. Between all three firms, I've been involved in the financing and development of about 200 companies in the past 22 years.

Those 200 companies have, on average, created a couple hundred jobs each over the 5-10 year period of our involvement with them. So that's about 40,000 jobs in total that the three firms I've worked in have helped to create over the past two decades.

Just to be clear, the number of jobs created per company has a wide distribution. Some have created thousands of jobs and others less than ten. My two hundred number is an educated guess and I have not done the work to determine an exact number.

But the news that our economy lost 75,000 jobs yesterday needs some context. That's a lot of jobs for sure but how much? Well, its basically double the number of jobs the companies I've been involved with over the past two decades have created.

There's a lot of talk about creative destruction and renewal and many are looking at the venture backed tech companies to lead the way in renewal and job creation. And I am among those who believe that tech-based entrepreneurship is a big part of the way out of the mess we are in.

But can we in the venture business collectively replace 75,000 jobs per day? No, we can't.

First of all, I sure hope we don't lose 75,000 jobs per day every work day this year. That would be 15mm jobs this year. I think a more realistic estimate of job loss this year is 3mm to 5mm. It could be more but I hope not.

There are about 1000 venture capital firms operating today. If my experience is typical, then each firm could be responsible for making investments each year that create about 2,000 jobs (40,000 jobs divided by 20 years). That's 2mm new jobs. But they don't all get created in the year of investment, it takes 5 to 10 years for the average company to grow to the average of 200 employees. And venture firms work together on deals so there's plenty of duplication in that number.

So the bottom line for me is that the venture capital business is not going to solve this problem we are in. We are going to play a role, possibly an important role, but we'll need more forms of job creation to get everyone back to work.

My friend Charlie O'Donnell may have a better answer, which is that entrepreneurship will have to do the heavy lifiting. As Charlie says:

Well, what if there are no openings come this May–literally none. 
No job postings.  No on campus interviews.  No job fairs.  This isn't a
fantasy.  It's happening right now.  Even the companies that are
showing up to job fairs aren't hiring–they're just there for branding.
Let's not even talk about the number of people getting laid off

You know what that makes all these students, and everyone else out there in the job market…

…besides screwed?


Charlie is talking about people coming right out of college, but I think this is going to be true for a lot of people who need a job going forward. The big companies are not going to be the answer. We are going to need more people going out on their own. Some will raise venture capital, but the vast majority will not. Some will bootstrap a business that hopefully can cover their cost of living. I think more jobs will get created this way than by venture financing.

And our portfolio company Indeed, which is the leading job search service on the web, posted today that there are pockets of strength in the economy that are not being talked about:

this belies myriad opportunities: hundreds of thousands of companies
are continuing to hire. While big layoffs are headline-grabbing,
gradual hiring in sometimes hidden corners of the economy often goes
unnoticed by the media.

Use Indeed’s job search to ferret out the jobs that fit your own background and our job trends
to see which jobs are in demand. If the industry you’re in is
struggling, find where you can deploy your skills in areas of the
economy that are growing.

The Indeed post has some very good suggestions so if you are looking for a job right now, you should go read it.

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Confessions Of A Pack Rat (aka My Document Retention Policy)

I keep everything that might ever be valuable and I hate to throw stuff out. It drives the Gotham Gal nuts. On most things, she wins. But when it comes to my office and my stuff, I win. It stays.

Yesterday my friend and former colleague Dan Malven sent me an email looking for the investment memo we wrote at Flatiron recommending our initial investment in in the winter of 1998/1999. Apparently Kellogg business school is doing a case study on that investment, as well they should. It was one of our really good investments at Flatiron.

I went to spotlight, typed sina and about six documents came up, including several drafts of the investment memo, the cap table, and a few other related documents. I put them in a folder, compressed them up, and sent them off to Dan and Kellogg. And I felt great. That's a little bit of history there, preserved by yours truly.

People are surprised that I save every important document and email. It goes against popular wisdom that you should shred, delete, and otherwise destroy documents so they can't be used against you in court.

Well I've been sued a few times and deposed a few more times. I've had to submit my relevent documents in discovery a bunch of times. And I've never been hurt by it. And in several instances, our case was helped dramatically by it.

Here's my thinking. If you are a bad person who does bad things to people, then by all means destroy the evidence before someone can get at it. But if you try to be a good person and do the right thing, then you should be saving the evidence so when someone tries to paint you as a bad person, you can pull out the email or document and wave it in their face and remind them who did what to whom.

I know that sounds terribly arrogant, self righteous and naive and it is at some level. Wrong and right aren't always so clear cut and sometimes an email can be read in a different light years later.

I take things like fiduciary responsibility and contractual agreements very seriously and try very hard to do the right thing and treat people well and fairly. There are people out there who will try to screw you over and paint you as the bad guy anyway. Having the smoking gun pays dividends big time and it would really suck if you shredded it or deleted it because of some stupid document retention policy.

I hope and expect this post will get some good debate and discussion. And I particularly hope the lawyers in the community stop by and weigh in. It's a worthwhile conversation to be having.

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